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Mutual fund managers may have a conflict of interest because of the way they are paid. In particular, mutual fund managers are encouraged to make risky investments that are not in the interests of unit holders, and to over-concentrate their holdings. Mutual fund investors, on the other hand, would tend to benefit from less risky investments, and greater diversification. This article will explore this conflict of interest and its implications for investors who buy actively managed mutual funds.

Imagine a game of heads and tails where you receive $10 if the coin comes up heads, but lose only $5 if the coin comes up tails. You have a very strong incentive to play this game--and that's pretty much the situation that active mutual fund managers find themselves in when they contemplate making a risky investment with your money. This is because of a well documented effect whereby mutual fund investors tend to reward success much more strongly than they punish failure.

Many mutual fund investors choose funds that have better than average five or ten year performance numbers. This is partly because people believe that a fund which has done well in the past will do well in the future; it is also because mutual fund companies actively promote and market their best performing funds to the public. I have argued that mutual fund performance is no indication of future returns but apparently too few mutual fund investors pay attention.

On the other hand, most mutual fund investors also follow a buy-and-hold strategy: Once they have invested in a fund they will stick with it for awhile no matter what. For one thing, investors have been taught that a buy-and-hold investment strategy is an effective strategy. Also, there are often financial penalties for withdrawing money from a fund within the first several years--many funds have deferred sales charges and other loads that penalize investors for early withdrawl. Finally, as Lynch and Musto point out, when a fund performs poorly fund managers generally announce a change of strategy, and this announcement mitigates investor's desire to withdraw funds.

As a result, a mutual fund that outperforms the market will see funds flood in as investors choose it over other mutual funds. Absolutely huge quantities of money flood into the top performing mutual funds. On the other hand, underperforming funds will see money flow out of the fund at a much slower rate. Overall, the rate of inflow to a successful fund is much higher than the outflow from an unsuccessful one.

Mutual fund managers are paid a percentage of assets under management, so their primary incentive is to attract as much money into the fund as possible. On the surface this seems to align their interests with mutual fund investors--the fund manager will be rewarded if the fund does well. However, that looks at only one side of the equation--the flip side is that fund managers should also be punished if the fund underperforms, and while they are, they are not punished nearly so much for failure as they are rewarded for success.

This puts the mutual fund manager into a conflict of interest with mutual fund investors. It is in the investor's best interest to make sound, sensible investments that have a good probability of paying off, with only a small chance that the investor will suffer a large loss. On the other hand, it is in the fund manager's best interest to make highly risky investments that create the potential for large inflows of money.

What kind of risky strategy might an active manager follow? Over-concentrating the funds holdings on a few securities in the hopes that one will payoff big would be one strategy. Investing a disproportionate amount of money in highly risky small-caps, foreign securities, or various options and derivatives would be another. None of these investment choices are inherently bad--but if the goal is to increase the risk so as to increase the chances of a high return, then this is probably contrary to the interests of the fund's investors.

This performance flow effect has been studied extensively in the academic literature. Ippolito (1992), Brown, Harlow, and Starks (1996), Gruber (1996), Chevalier and Ellison (1997), Goetzmann and Peles (1997), Sirri and Tufano (1998), and Del Guercio and Tkac (2002) have all looked into it. The effect is persistent and pervasive: Investors reward success much more strongly than they punish failure.

The implication is that mutual fund investors should be wary of selecting funds based on their past performance, and on the lookout for active managers who seek to increase their own net worth by making unacceptable gambles with fund investor's money. One way to avoid this is to invest only in indexed mutual funds where fund managers do not make active decisions.

It's worth pointing out that many fund managers overcome this conflict of interest and attempt to trade in the best interests of their unit holders. The existence of a conflict of interest does not mean that fund managers will expropriate investor's money--it's just a big caveat emptor: Let the mutual fund buyer beware.

I agree that it is in the fund manager's best interest to attract interest in a fund as he is rewarded on the success of the fund. Also it is in the interest of the financial planner who uses certain fund managers and funds when negotiating fees. It is in my opinion even more of a conflict of interest if the Asset Management firm sells his clients to another Asset Management company eventhough he is still the managing the portfolios of his clients in this new association.